Unit 4 Missed Questions - Series 7

The following is taken from the S&P Bond Guide: FLB Zr 37 87 87½. What is the coupon rate on this bond? A) 0% B) 8.75% C) 8.70% D) 0.37%

A) 0% FLB is the issuer, Zr means zero coupon, 37 indicates the year of maturity (2037), 87 is the bid price ($870), and 87½ is the asked price ($875). LO 4.e

Which of the following provisions of a new corporate debt issue would be least attractive to a potential investor? A) A low call price B) A sinking fund C) Significant collateral D) A high nominal yield

A) A low call price Investors can be wary when it comes to callable bonds. When interest rates decline and the investors are smiling over the higher than market rates they are earning, along comes the issuer and calls that bond in. The lower the call price, the more attractive it is for the issuer, not the investor. A sinking fund is like the escrow account on a home mortgage. Money is being put aside to make sure that when it is due, it is there. Obviously the investor would prefer a higher coupon (nominal) yield than a lower one and collateral always adds to the security of the debt. LO 4.b

Which of the following would be considered an equity security? A) Preemptive rights B) Exchange-traded notes C) Negotiable CDs D) Equity-linked notes

A) Preemptive rights Rights (and warrants) are included in the term equity security. Confusingly, equity-linked notes are debt securities, even though the term equity is in the name. On this exam, notes always represent a form of debt security. LO 4.g

The XYZ Corporation has issued some 4% callable bonds maturing in 20 years. The bonds are callable at 102 commencing in 10 years. Regarding these bonds, which of the following statements is not correct? A) These bonds will appreciate faster in declining interest rate markets than comparable bonds without a call feature. B) The bonds will likely be called in a declining interest rate market, forcing the bondholders to reinvest at lower rates. C) The call premium generally will not compensate the bondholder for the loss of interest if the bond is called. D) XYZ will most probably call these bonds when it can refund the issuer at a lower interest rate.

A) These bonds will appreciate faster in declining interest rate markets than comparable bonds without a call feature. All things being equal, callable bonds will not show as much appreciation in a declining interest rate market as bonds without a call feature. Logically, as interest rates fall, those bonds will be called making them less attractive than bonds where the higher interest rate payments will continue until maturity. It is correct that the premium ($20 in this question) is generally not going to equal the amount of interest that the investor would have been able to earn on the bond. It is some compensation, but not full. The bonds will be called when interest rates have declined, and the investor will now have the cash but faces the reinvestment risk of having to put the money to work at those lower interest rates. LO 4.b

When a corporation issues a debt security, the terms of the loan are expressed in a document known as the bond's indenture. The indenture is sometimes referred to as A) the deed of trust. B) the bond resolution. C) the debenture. D) the loan agreement.

A) the deed of trust. The indenture, sometimes also referred to as the deed of trust, states the issuer's obligation to pay back a specific amount of money on a specific date. A debenture is a debt security containing an indenture. The bond resolution is a term used for municipal bonds not corporate debt. LO 4.a

Nickelplate Manufacturing Corporation (NMC) is capitalized with 1 million shares of a 6% $50 par callable preferred stock and 10 million shares of $1 par common stock. With the preferred stock currently selling at $75 per share and the common stock at $60 per share, the current yield of the preferred stock is closest to A) 8%. B) 4%. C) 6%. D) 5%.

B) 4%. Current yield on any security, stock or bond, is the annual income (dividend on stock, interest on bond) divided by the current market price per share (or per bond). The math in this question is the dividend of $3 (a 6% $50 par preferred stock is paying an annual dividend of 6% of $50, or $3 per share) divided by the current market price of the preferred stock ($75). The quotient is .04 or 4%. What about the common stock? All of that information is just to distract you. We cannot compute the current yield of the common stock because we do not have any information about its dividend. LO 4.e

A bond with a 9% coupon, maturing in 18 years and 6 months, is selling at 120. The yield to maturity is closest to A) 11.66%. B) 7.05%. C) 7.50%. D) 9.00%.

B) 7.05%. Don't waste time trying to do the yield to maturity computation. This bond is selling at a premium (120% of par). Therefore, all of the computed returns must be lower than the 9% nominal (coupon) yield. Only two of them are. The 7.50% represents the current yield ($90 ÷ $1,200). We know from our charts that, just like a seesaw, the farther from the center you go, the bigger the move at the end. That means the nominal yield is the highest, followed by the current yield (CY), the yield to maturity (YTM), and finally the yield to call (YTC) as the lowest. Because only one choice is lower than the CY, you get the correct answer with minimal effort. LO 4.e

Which of the following callable municipal bonds trading on a 7% basis is most likely to be called? A) 6.5% coupon, callable at 100 in 2030 B) 7.5% coupon, callable at 100 in 2030 C) 6.5% coupon, callable at 105 in 2030 D) 7.5% coupon, callable at 105 in 2030

B) 7.5% coupon, callable at 100 in 2030 An issuer will call the higher coupon bonds before calling the lower coupon bonds. Of the two bonds with coupons of 7.5%, the one with the lower call price will likely be called first. LO 4.e

An investor is concerned about safety. When consulting the ratings, which of the following securities would appear to be least likely to default on its obligation to make timely payment of interest and principal? A) AAA rated common stock B) AA rated debenture C) A rated mortgage bond D) BB rated sovereign debt

B) AA rated debenture When it comes to reducing default risk, "the As have it." That is, the more As in the rating, the lower the default risk. True, the common stock is rated triple A, but stock has no obligation to pay interest and repay principal. Why isn't the mortgage bond a safer bet than the debenture? Aren't secured bonds the safest? These are good questions, but the rating services take that into consideration when giving a rating. In their eyes, the debenture, an unsecured debt, merits a double A rating while the mortgage bond, even with the pledged collateral, can only be awarded a single A rating. Sovereign debt, the debt of a country's government, is usually quite safe, but history has shown us that governments can, and do, default. The BB rating here indicates a certain question as to the safety. LO 4.f

Which of the following instruments is essentially a letter of credit? A) Negotiable CDs B) Bankers' acceptances C) Commercial paper D) Margin loans

B) Bankers' acceptances A letter of credit (LOC) is a commitment, usually made by a commercial bank, to honor demands for payment of a debt upon compliance with conditions and/or the occurrence of certain events specified under the terms of the letter of credit. Those in the import/export business use these LOCs in the form of bankers' acceptances. **This question deals with material not covered in your LEM, but it relates to recent rule changes and/or student feedback. LO 4.c

Most rating services rate which of the following? A) Durability B) Quality C) Reinvestment risk D) Marketability

B) Quality The rating services are concerned with quality, which is defined as the ability of the issuer or guarantor to pay (default risk). LO 4.f

A bond analyst plots the yields of AAA corporate bonds and compares them to the yields of U.S. Treasury bonds with similar maturities. This is known as A) yield plot analysis. B) yield curve analysis. C) inverse yield analysis. D) yield comparison analysis.

B) yield curve analysis. The plotting of bond yields results in a curve, usually one where the longer the time to maturity, the higher the yield. The term yield curve analysis is the proper way to describe comparing the yields of highly-rated corporate bonds to those of Treasury bonds. When the spread between the yields is narrow, economic conditions in the United States are generally favorable. If the spread (sometimes called the credit spread) widens, it is generally a sign of a worsening economy. ** This question deals with material not covered in your LEM, but it relates to recent rule changes and/or student feedback. LO 4.f

Nickelplate Manufacturing Corporation (NMC) is capitalized with 1 million shares of a 6% $50 par callable preferred stock and 10 million shares of $1 par common stock. Your customer's required rate of return on fixed income investments is 8%. The NMC preferred stock would be an appropriate addition to this customer's portfolio only if the stock was not priced in excess of A) $66.66. B) $40.00. C) $37.50. D) $75.00.

C) $37.50. How does a 6% preferred stock return 8%? Remember the inverse relationship between interest rates and fixed income security prices. As one goes up, the other goes down. An increased return results from a decreased price. The math is basic algebra. We know the annual dividend is $3 per share (6% of $50 = $3); that is fixed. What number results in a payment of $3 providing an 8% return? Divide 3.00 by $8 and the answer is $37.50. You could also do this question by working backwards. Multiply each of the choices by 8% and the one where the product is $3 is correct. LO 4.e

The ELLA Distributing Company issued a bond with a nominal yield of 5%. The bond matures in 12 years and is currently trading at 94. The bond's yield to maturity is closest to A) 5.32%. B) 5.00%. C) 5.67%. D) 4.64%.

C) 5.67%. The first point to notice is that the bond is trading at a discount. When bonds trade at a discount, our yield chart and example tells us that the yields, in ascending order, are nominal yield, current yield, yield to maturity, and yield to call. That last one is of no relevance to this question because a call feature is not mentioned anywhere. Therefore, we know that the yield to maturity must be greater than the nominal (coupon) yield of 5%. There are only two choices that are, so if you are running out of time or do not remember how to do this, at least you have a 50% chance. However, 50% doesn't pass the exam, so let's make that 100%. The yield to maturity computation is tricky, but current yield is not. It is simply the coupon divided by the current market price. In our question, that is 5% divided by 94 equals 5.32% (or $50 divided by $940). We know the yield to maturity for a bond selling at a discount is higher than its current yield. That means the correct answer must be greater than 5.32%. If you have a question like this on the actual exam, there will be only one choice higher than the current yield. As shown in the LEM, the YTM calculation goes like this: [annual interest + (discount divided by the number of years to maturity)] divided by the average price of the bond Plugging in the numbers, we get a numerator of $50 + ($60 divided by 12 years) = $50 + $5 = $55. The denominator is ($940 + $1,000) divided by 2 = $1,940 divided by 2 = $970. Solve by dividing $55 by $970 and the answer is 5.67%.

A 5% bond is trading at a premium. Which of the following would be the bond's highest yield? A) Dividend yield B) Current yield C) Coupon yield D) Yield to maturity

C) Coupon yield If a bond is trading at a premium, its coupon rate will represent the highest of its yields. Bonds do not have a dividend yield. LO 4.e

Which of the following is an example of sovereign debt? A) Sony Corporation debentures B) Royal Bank of Canada CDs C) U.S. Treasury bonds D) Bank of England notes

C) U.S. Treasury bonds Sovereign debt represents loans to governments. On the exam, it is likely that the examples will be foreign governments, not U.S. Treasury securities. The Royal Bank of Canada is a privately owned corporation and its debts are not those of the Canadian government. Bank of England notes are the paper currency issued (e.g., the ₤10 and ₤20 notes). LO 4.d

If the dollar price of a municipal bond is 101 and, at that price, the basis is 6.10, the nominal yield is A) less than the coupon rate. B) exactly 6.10%. C) greater than 6.10%. D) less than 6.10%.

C) greater than 6.10%. Basis is a common synonym for yield to maturity, especially for municipal bonds. For any bonds trading at a premium, the nominal yield (or coupon) is higher than the basis (YTM). For bonds at a premium, yields from lowest to highest are as follows: yield to call, yield to maturity, current yield, and nominal yield. LO 4.e

The Union Fidelity Bank of Highville has issued jumbo CDs with a term of three years and a fixed interest rate of 3.5%. The minimum denomination of the CDs is $100,000, and the CDs are callable at 101% of face value beginning on the first anniversary of the issue date. Under which of the following circumstances is it most likely that the bank would exercise the call feature on that anniversary date? A) Three-year jumbo CDs are currently being issued with a fixed interest rate of 3.5%. B) One-year jumbo CDs are currently being issued with a fixed interest rate of 4%. C) Three-year jumbo CDs are currently being issued with a fixed interest rate of 4%. D) Five-year jumbo CDs are currently being issued with a fixed interest rate of 2.7%.

D) Five-year jumbo CDs are currently being issued with a fixed interest rate of 2.7%. As is the case with other fixed payment callable issues, whenever interest rates decline, it is generally beneficial to call in the older issue. In this case, the bank would pay an extra 1% to redeem but could refinance at a rate that is at least .8% lower and extend the maturity. We say at least .8% lower because with the new five-year CDs paying 2.7%, if the bank wanted to keep to the same final maturity date (two more years), it is expected that the rate on two-year CDs would be lower than that of CDs with a five-year maturity. LO 4.c

An investor might expect to receive the greatest gain on an investment in a corporate bond by purchasing A) short-term bonds when interest rates are low. B) long-term bonds when interest rates are low. C) short-term bonds when interest rates are high. D) long-term bonds when interest rates are high.

D) long-term bonds when interest rates are high. If an investor purchases bonds when market interest rates are high, a drop in interest rates will lead to a corresponding increase in bond value. Long-term debt instruments will fluctuate to a greater degree than those with short-term interest rates. Thus, long-term debt offers the greater chance of gain. LO 4.b

Moody's Investment Grade (MIG) ratings are applied to A) municipal bonds. B) money market instruments. C) corporate bonds. D) municipal notes.

D) municipal notes. Moody's Investment Grade ratings are applied to municipal notes, which are short-term municipal debts such as bond anticipation notes (BANs) and tax anticipation notes (TANs). Aren't these short term notes considered money market instruments? Yes they are, but as is so often the case on the exam, the correct answer is the one that is most specific. That is, MIG ratings apply only to muncipal notes. There are many other kinds of money market instruments that Moody's rates, but not using the MIG description. LO 4.f

When a bond is issued by a national government, it is referred to as A) high-quality debt. B) national debt. C) treasury debt. D) sovereign debt.

D) sovereign debt. The term sovereign debt applies to securities issued by national governments. U.S. Treasuries are an example of sovereign debt issued here. Other countries have their versions, such as the Gilts of the United Kingdom. These are not considered alternative investments. Alternative investments are structured products that are complex and not easy to understand. Two of the most popular structured products are the ELNs and the ETNs. LO 4.d

When a bond is selling at a discount A) the yield to maturity will always be lower than the current yield. B) the current yield will always be higher than the yield to call. C) the yield to call will always be lower than the yield to maturity. D) the nominal yield will always be lower than the current yield.

D) the nominal yield will always be lower than the current yield. When a bond is selling at a discount, all of the yields are higher than the nominal (coupon) yield. The sequence in ascending order of yield is NY, CY, YTM, YTC. LO 4.e